It is one of the biggest dilemmas in investing: You have done your research and identified and purchased a good company in a profitable industry with enlightened, hardworking, shareholder-oriented management. You paid a reasonable price for the stock relative to your estimate of the underlying business value. You've owned the stock for a while, enjoyed some nice gains, and have started to develop an emotional bond with the company. Then, out of the blue, something bad happens to the company, the stock blows up, and you are left wondering what to do. Do you sell, do you hold, or do you buy more? Do you wait for more information, or do you act with your gut and buy more while the bad news is still fresh and you can almost taste the fear?
Such was my predicament recently when one of my favorite stocks, Utah Medical Products
A regulatory battle heats up
This direct attack appeared to be nothing less than a full declaration of war in what had become something of an ongoing border skirmish between the agency and Utah Medical. The relationship had become hostile after the FDA's decision in April 2003 to withhold issuing certificates to foreign governments, which, according to the 2003 Utah Medical annual report, "act as comfort letters for regulators in other countries"; the decision had a "retarding effect" on the company's international sales growth. Also in the annual report, CEO Kevin Cornwell disclosed that the company had filed a lawsuit against the agency.
Utah Medical had engaged in some press release warfare of its own, issuing one on Feb. 11 titled "UTMD Questions FDA Performance" that disclosed the FDA warning letter and quoted Cornwell as being "disappointed and bewildered by the performance of the FDA" and "concerned that the FDA intends to further tarnish UTMD's good reputation through a motivation that has nothing to do with the safety or effectiveness of our devices." The company followed up with additional remarks voicing its dissatisfaction with the FDA's handling of the situation in a press release on March 4, as well as in its first- and second-quarter earnings press releases. So perhaps I shouldn't have been surprised by the FDA's answering salvo, but I was.
New information, new price
One of the lessons I have learned since I've been managing money professionally is to avoid any kind of reflex action to any new development that dramatically moves a stock. When a stock that I like sells off, usually my first reaction is to want to buy more. For other people, the initial reaction when they see their stock tank 30% in an hour is to panic and sell before they lose more money. I have learned that neither reflex is good; rather, the thing to do is quickly and efficiently reassess the new information, get some crystallization on what the effects on the business are likely to be, and make a rational decision based upon that review and in light of the new stock price.
The intermediate outlook for Utah Medical appears very uncertain in light of what appears to be an acrimonious and entrenched battle with a government regulatory agency. While I would hope that some favorable resolution can be reached quickly, the damage to the business could be substantial if this turns out to be a protracted legal battle. A press release on Aug. 31 disclosed that the FDA's press release has already caused "significant disruption" to the business, in part because of Utah Medical competitors telling customers that the company will be shut down by the FDA shortly. Already, the company has issued a press release offering a 10% discount to hospital customers ordering products directly from it. Unless it's offset by greater sales volume, such discounting can only have a negative effect on profit margins.
On the positive side, the company also noted that "in the three weeks since the FDA press release the total dollar value of orders has remained about normal." Of course, the longer this situation drags on, the harder it may be for Utah Medical to maintain its level of business. And one thing I do know is that the management and board doesn't back down from a fight, to which Tyco
Making the call
In trying to decide which way to go, it became readily apparent to me that I had no way of evaluating with any real accuracy the various possible outcomes of the dispute between Utah Medical and the FDA. I simply don't have the expertise or the experience with such regulatory spats to be able to handicap a likely outcome; I'm not sure that in this case anybody does. I do see potential for at least moderate and possibly significant damage to the company's business in all scenarios except a resounding legal victory against the FDA that carries with it a damage award sufficient to cover any financial damage Utah Medical suffered. Given my risk-averse nature, combined with the stock's recovery to more than $19 -- which represents only a modest discount to my estimate of fair value -- I felt there was nothing to do but sell our small remaining position in the stock. There were a few other factors that weighed on the decision. The first was that Utah Medical was a very small holding for us, since we had steadily trimmed the position in the mid-$20 range when it was, in our view, fairly valued. Second, there were no negative tax consequences to the sale.
I have to admit to having some emotional resistance to selling the stock. I have developed a strong affinity for this company over the years; I like and respect the management team. As much as I wish I were more Spock-like when it comes to my investing, emotion is a part of the investing game, and controlling emotional responses is probably the hardest part of the craft to master. My emotional response in this case was a sense of guilt for abandoning a good company in its time of hardship. This reaction is not hard to overcome logically -- I just have to remind myself that I owe no allegiance to any given stock; rather, my responsibility is to protect the capital of my investors. My admiration for the management and employees of Utah Medical will not be diminished. Going forward, we will monitor the situation and hope for an opportunity to re-establish an investment when the risk can be better assessed and the price offers a reasonable probability of satisfactory returns.
Guest columnist Zeke Ashton has been a longtime contributor to The Motley Fool and is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At the time of publication, neither Ashton nor Centaur Capital Partners held any beneficial interest in any company mentioned in this article. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Please send your feedback to firstname.lastname@example.org. The Motley Fool is investors writing for investors.